According to the Arcadia Association of RealtorsA!X (A.A.R.), a short sale in California is generally not subject to federal income tax for mortgage debt forgiveness. This is from a recent letter written by the Internal Revenue Service (IRS) to CA Senator Barbara Boxer. The California Association of RealtorsA!X (C.A.R.) worked closely with Senator Boxer to obtain this IRS guidance. The A.A.R. is also hopeful that C.A.R. can promptly obtain similar guidance regarding state income tax for mortgage debt relief income from the California Franchise Tax Board (FTB), which has been awaiting this IRS letter.
The IRS clarified in this letter that California’s troubled homeowners who sell their homes in a short sale are not subject to federal income tax liability on “phantom income” they never received. The IRS recognizes that the debt written off in a short sale does not constitute recourse debt under California law, and thus does not create so-called “cancellation of debt” income to the underwater home seller for federal income tax purposes. According to A.A.R. 2013 President Andy Bencosme, “This clarification rescues tens of thousands of distressed home sellers from personal liability upon expiration of the Mortgage Forgiveness Debt Relief Act of 2007 on Dec. 31, 2013.”
Given that a homeowner in California generally cannot be held personally liable for a short sale deficiency (see below), the IRS stated in its letter that it would consider the mortgage loan as a nonrecourse obligation that is not subject to federal debt relief income tax. The amount of indebtedness, however, must be reported as the amount realized for capital gains purposes. Of course, a principal residence is generally excluded from capital gains tax up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns (under 26 U.S.C. !!O 121).
As background, California law generally protects a borrower from owing a deficiency after a short sale of a residential property with one-to-four units, including both first and junior trust deeds (Cal. Code of Civ. Proc. section 580e). Exceptions include fraud, waste, cross-collateralized loan, and a borrower that is a corporation, LLC, or limited partnership.
Although short sale sellers of a qualified principal residence are currently protected against federal debt relief income tax under the Mortgage Forgiveness Debt Relief Act of 2007, that federal law is set to expire on December 31, 2013, whereas the tax exemption set forth in the IRS letter has no expiration date. Similar protection to the federal Mortgage Forgiveness Debt Relief Act for state income tax under California law has already expired on December 31, 2012. However, other exemptions from federal and state taxation of debt relief income are available, such as for bankruptcies and insolvencies. The Arcadia Association of RealtorsA!X encourages all potential and previous home sellers to seek the advice of a tax professional regarding the tax consequences of a short sale.
Representing local RealtorsA!X in the San Gabriel Valley for 89 years, the ARCADIA ASSOCIATION OF REALTORSA!X (www.TheAAR.com) is one of the oldest trade organizations in CA. The AAR is dedicated to the advancement of professionalism in real estate and is an advocate for private property rights. A.A.R. is headquartered in Arcadia.